Cross-Country CIP Deviations

Deviations from Covered Interest Parity (CIP) vary systematically across countries and are strongly correlated with cross-country differences in interest rates, net foreign asset positions, and the extent of hedging of dollar exposures. We develop a macroeconomic model of the United States and a set of smaller advanced economies that introduces cross-country heterogeneity to account for these empirical relationships. The model is disciplined by evidence on the main participants in FX derivatives markets and their underlying hedging motives. We allow for heterogeneity in wealth, productivity, and safe-asset supply. Analytical results characterize how each source of heterogeneity affects CIP deviations, and a calibrated version of the model is shown to match key cross-sectional patterns in the data. In particular, heterogeneity in wealth—captured by differences in saving behavior across countries—emerges as the primary mechanism consistent with the observed evidence.